Top White Collar Cop Inspects Dodd-Frank

We talked recently with the state’s top securities regulator about the Dodd-Frank Financial Reform Act, designed—with many policy details still to be fleshed out—to address the ongoing financial crisis. Then we asked him whether the financial crisis amounted to systemic fraud.

Joseph Borg is director of the Alabama Securities Commission, a post he has held since 1994. His enforces the Alabama Securities Act, which governs securities fraud and requires the registration of broker-dealers, agents and investment advisers. Borg has twice served as head of the North American Securities Administrators Association, earning the headline “Wall Street’s Worst Nightmare, ” in a Forbes magazine profile in 2002, when Berg successfully argued that big firms were answerable to state regulations, as well as national SEC requirements. He is a delegate to the International Expert Group for the United Nations Commission on International Trade Law.

The Dodd-Frank Act is some 2, 300 pages long and demands some 100-plus studies from the SEC and other agencies, so there are a lot of details yet to be determined. But a big area that affects our department has to do with investment advisor companies. Investment advisers with assets of $25 million to $100 million under the old law used to be regulated by the SEC, but now, under the new law, will be regulated by state agencies like ours. Each investment advisor company has employees that we will end up licensing. Nationally, that includes 4, 000 or more firms and all the agents that work for them. For us in Alabama, that is 50-some new companies we are responsible for and their employees. Basically, for the state, it’s another unfunded federal mandate.

If you look at the SEC’s record for examining these firms, the average is one examination for every 30 years. The rationale is that the states will be more capable of handling these within their own jurisdictions, rather than the SEC working out of Washington. I supported this change for the protection of my citizens in Alabama. If the SEC can’t do it, I’d rather take on the burden and do it once every three years, which is our intention. We’ll increase by about 50 percent our workload, because of the difference in the scale of assets we have to examine. It’s easier to audit $25 million in assets, and now we’re talking about four times that much in scale.

With Dodd-Frank, we have gotten some further disclosures with regard to Regulation-D private offerings. We call this change the bad boy disqualifier act, and it’s something we pushed for. Under the new law, the SEC is required to check a Reg-D filer’s past history to see if they have been barred by a state from doing business. It has been a problem for us in Alabama because of companies that come into the state, soliciting Alabama residents and filing on a federal level, and we get no notice. They go out and raise the money and within 15 days of the sales in Alabama, the federal officials are supposed to tell us, after the fact. In the past, because we weren’t the ones giving them a license, we couldn’t do the background check. But now, with the change, we can do the gatekeeper function.

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Dodd-Frank requires the SEC to do a study with regard to fiduciary duty and stockbrokers. Currently, a stockbroker owes a duty of suitability: Whether an investment is suitable for you. An investment advisor, however, is under the higher fiduciary standard: Even if it cuts into their commission, they have to look out for the client’s best interest.

We’ve been pushing for the fiduciary standard to be applied to stockbrokers, and the FCC, after years and years, is recommending that the standard be the same. The brokers, of course, don’t agree. They are absolutely apoplectic right now at the prospect.

That’s a big area that we would implement. If a stock broker were under the best fiduciary standard and we found out he was selling all the old people the wrong investment just to make a 1 percent commission, we’d be pulling your license.

The things that caused the systemic financial crisis should have been recognized up front, but I’m not sure there was intent to defraud. It should have been apparent to regulators and the insurance agencies and the banks and the mortgage brokers. But so long as everybody is busy making his or her commissions and cuts, that doesn’t happen. 

Freddie Mac and Fannie Mae were part of the problem, and they fed the appetite for more securitization of real estate and the laxity by those who originated the mortgages. Basically, they were lying about the income and jobs of the applicants, and that was fairly well known throughout the industry, and Wall Street knew they could make a ton of money by selling these products.

When I speak in public about the subject, I like to use this story. A lady named Heidi has a bar in Detroit. One day Heidi realizes all her customers have become unemployed alcoholics and can't come to her bar anymore. So Heidi comes up with a new marketing plan: Drink now, pay later. She keeps track of all the drinks on a ledger. As a result, customers flood her bar; she has the largest sales of anybody in Detroit. Owing to the freedom from immediate payment demands, she increases her prices for wine and beer and her gross sales increase massively, and the guy at the local bank says, “Wow, I’m going to increase her borrowing limit.” She has all this collateral in these IOUs, and so, someone at the bank’s corporate headquarters figures a way to make even more money off Heidi by transforming her drink IOUs into securities and trading them on the international securities market. Most investors do not have a clue as to the risk involved, because they are sold as AAA-rated by some rating agency, although in reality they are the debts of unemployed alcoholics. For a while, the demand for Heidi’s drink bonds keeps going up and up and up. Then one day at the bank someone says, “Hey, we have to get Heidi to pay down some of these loans.” So Heidi has to ask her customers for payment, and they say “Sorry, I can’t pay you back.” And Heidi is forced into bankruptcy, and the bar closes and all 11 employees lose their jobs, and the drink prices drop 90 percent and it destroys the bank’s liquidity and all the liquidity in the community freezes. The wine and beer supplier goes into bankruptcy and lays off 150 workers. The people who invested all their money in those drink funds now have to write off 90 percent of the bonds. But the bank is bailed out by the taxpayers.

Chris McFadyen is the editorial director of Business Alabama.

Interview by Chris McFadyen

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